Download Interest Rate Swaps – example 11

Interest Rate Swaps – example 11
Example 11: Using a floating for fixed interest rate swap to hedge out cash flow risk
Entity A issued 5 year bonds on 1 January 2010 for R1 million. The bonds bear interest at prime +
2% per annum, paid semi-annually in arrears. The bonds are measured at amortised cost.
On 1 July 2011, the financial manager was of the view that interest rates were increasing and
consequently decided to hedge out “potential losses” of having to pay high market interest rates.
Interest rates
Expected interest rates
Fixed interest rate
time
What risk relating to the fixed interest rate on the bond, is entity A exposed to (fair value or cash
flow) and why?
On 1 July 2011, the financial manager entered into a two year interest rate swap agreement with a
notional amount of R1 million. In terms of the interest rate swap agreement, the entity will receive
a 6 month floating interest rate of prime + 2% p.a. and pay a fixed semi-annual interest rate of 7%.
Assume that net payments on the swap agreement are settled every six months, at which date the
variable rate payable during the following six months is set.
The prime interest rates for the six months ending on the respective dates were as follows:
1 January 2011:
10%
1 July 2011:
11%
31 December 2011:
14%
At 31 December 2011 and at 31 December 2012, the prime interest rate was expected to remain 14%
for the remaining life of the bonds.
Assume that the fair value on the hedged item is the same as that of the hedging instrument for the
years ended 31 December 2011 and 31 December 2012.
You are required to:
A. Prepare the journal entries required to account for the bond and the IRS for the year
ended 31 December 2011.
B. Prepare the journal entries required to account for the bond and the IRS for the year
ended 31 December 2012.
WORKINGS FOR PART A:
1. Movement in fair value of the interest rate swap (hedging instrument)
At inception of the interest rate swap (IRS) agreement, the fair value is nil. This is because when the
instrument is issued, the entity issuing the IRS expects the overall PV of the net cash flows to be nil,
i.e the total net cash flow (received less paid) is expected to be nil. However the market interest rates
will inevitably move differently to the expectations of the issuing entity (bank). Consequently the
fair value of the swap is calculated at year end and approximates the present value of expected future
net cash flows.
YEAR END
Interest rate swap
Receive variable
Pay fixed
Net cash flows
Dec-11
65 000
-70 000
-5 000
Jun-12
80 000
-70 000
10 000
Dec-12
80 000
-70 000
10 000
Jun-13
80 000
-70 000
10 000
PV future expected cash inflows
Clean value (fair value excluding current year cash outflow of R5 000) is calculated as
follows:
Pmt= R10 000
N= 3
i = 8% (14% + 2%) x 6/12 months
PV = R25 771
The movement in the fair value for the year ended 31 December 2011 is therefore a gain of
R25 771.
2. What is the hedged item?
SOLUTION FOR PART A
Journal entries for hedge accounting at 31 December 2011
Accounting for the current year interest
1
Dr interest expense
125 000
Cr Bonds
125 000
Interest on bonds at a semi-annual effective interest rate of 6% from Jan to June and
6.5% from July to Dec.
2
Dr Bonds
Cr Bank
Payment of coupon in June 2011 and December 2011
3a
125 000
Dr Interest expense (loss on swap)
5 000
Cr Bank
5 000
Net cash flow arising from IRS (receive 6.5% variable and pay 7% fixed) x R1m
Accounting for fair value changes of future anticipated swap cash flows
4a
Dr Swap (receivable)
25 771
Cr Cash flow hedge reserve (OCI)
Transfer of “clean fair value” of swap to cash flow reserve
3b
125 000
25 771
journals 3a and 4a could have been replaced with the following entries:
Dr Swap (receivable)
20 771
Cr Cash flow hedge reserve (OCI)
20 771
“Dirty” value of swap transferred to the cash flow hedge reserve. Dirty value is the fair value
of the swap INCLUDING the cash flow settled at the end of the current year.
4b
Dr Swap
5 000
Cr Bank
5 000
Current year net cash outflow settled against the swap “payable/receivable” account
5
Dr interest expense (loss on swap)
5 000
Cr Cash flow hedge reserve (OCI)
5 000
Releasing FV adjustments on hedge relating to current year exposure from hedge
reserve
Total interest expense for the year ended 31 December 2011
Effective interest rate on bond
Interest effect of hedge
R
-125 000
-5 000
-130 000
This hedge is perfectly effective. The total interest expense reported represents interest at a
floating rate of 6.0% for 6 months (unhedged) and interest at a fixed rate of 7% for the second
six months of the year (hedged).
WORKINGS FOR PART B:
1. Movement in fair value of the interest rate swap (hedging instrument) in year 2
Calculation of FV of swaps at end of December 2012
YEAR END
Interest rate swap
Receive variable
Pay fixed
Net cash flows
Jun-12
80 000
-70 000
10 000
Dec-12
80 000
-70 000
10 000
Jun-13
80 000
-70 000
10 000
PV future expected cash inflow
Clean value (fair value excluding year end cash inflow of R10 000) is calculated as follows:
Pmt= R10 000
N= 1
i = 8% (14% + 2%) x 6/12 months
PV = R9 259
The movement in the fair value for the year ended 31 December 2012 is therefore a loss of R16 512
(R25 771 – R9 259).
SOLUTION FOR PART B
Journal entries for hedge accounting at 31 December 2012
Accounting for the current year interest
1
2
Dr interest expense
160 000
Cr Bonds
Interest on bonds at a semi-annual effective interest rate of 8%
160 000
Dr Bonds
160 000
Cr Bank
Payment of coupon in June 2012 and December 2012
160 000
3a
Dr Bank
20 000
Cr Interest expense
Net cash flow arising from IRS (7% fixed less 8% variable) x R1m x 2 periods
20 000
Accounting for fair value changes of future coupon payments and anticipated swap
cash flows
4a
Dr Cash flow reserve (OCI)
16 512
Cr Swap
16 512
Cash flow reserve reflected at cumulative effective hedge
3b
4b
5
, journals 3a and 4a can be replaced with the following:
Dr Bank
20 000
Cr Swap
Settlement of net cash flow against the receivable (swap account)
Dr Cash flow reserve (OCI)
Cr Interest expense
Release of current portion of hedge from hedge reserve
20 000
20 000
Dr Swap (receivable)
Cr Cash flow hedge reserve (OCI)
Cash flow reserve reflected at cumulative effective hedge
20 000
3 488
3 488
Total interest expense for the year ended 31 December 2012
Effective interest rate on bond
Interest effect of hedge
R
-160 000
20 000
-140 000
The total interest expense reported for the period is therefore R140 000 which is what one would
expect as we have swapped the floating semi-annual rate of 8% for a semi-annual fixed rate of 7%
during the whole year.
Please note, that in this example the hedge was perfectly effective. In the instance when the hedge is
not perfectly effective, then the interest reported may not be exactly at the fixed rate of 7% as it will
include some ineffectiveness.